February 2010
Have you been as puzzled by how Bernie Madoff pulled off possibly the biggest and longest running scam in U.S. history? How did really smart people fall for his $50-65 billion Ponzi Scheme* and remain gullible for decades? My curiosity about this seeming impossibility prompted me to dig a bit into the Madoff con, read his pre-trial plea confession, review the history of his career and research articles and interviews since his scam came to light in late 2008.
We often hear how con men capitalize on people’s greed, the idea of getting something for nothing or very little, making a killing by getting the better of someone else. And this probably is fairly accurate for the pyramid chain letter or the Nigerian email scam. “Too good to be true” is usually exactly that.
But Madoff’s clients did not strike me as the greedy types, hoping to get something for nothing. Greed was certainly alive and well amongst those making millions on the illusion but most of the victims of this horrendous crime seem to be good-hearted people and institutions, some humanitarian and philanthropic. They were hard-working people who invested their entire fortunes in some cases, trusting this man who appeared to have the Midas Touch, and who was admired by peers and regulators alike. He had credibility, reputation and rubbed shoulders with the power elite of Wall Street. It seemed such a safe bet to place your funds in his hands especially when most were referred by trusted friends who were also unwitting victims of his swindles.
So how did he dupe all these people? How did financially sophisticated professionals and wealthy investors and, in particular, regulators like the SEC and NASD get taken in by this con man? For instance, the SEC spent most of 2006 and 2007 investigating Madoff after finally responding to multiple reports of wrongdoing by a colleague who had been blowing the whistle since 2000. After nearly two years of “investigation” they closed the file because they “found no evidence of fraud” although they discovered a few administrative violations. The SEC investigators reported that Madoff and his associates had “voluntarily remedied the uncovered violations, and because those violations were not so serious as to warrant an enforcement action.” Remarkably, he passed their investigation although all he was doing was putting investors’ money in a bank account at Chase, never investing any of it!
What is even more remarkable is that if it were not for the 2008 crash and recession, Madoff may still be in business! In other words, he was brought down by happenstance – not through any enforcement intervention – because he was unable to raise enough new money in the historic downturn to keep up the scam.
Clearly, something went terribly amiss here. When I see systemic crashes like this I try to look for contributing factors where others may not be looking. Obviously there was the masterminding of a huge fraudulent scheme, an illegal act. Also obvious albeit mystifying is the ineptitude of the regulators and the utter failure of the system designed to protect investors and punish criminals of this kind. But instead of doing a morality assessment of the perpetrators of the scam I wanted to look for other possible factors that allowed this to happen.
What role, if any, did the investors have in all this?
The word that occurred to me was “pretense.” Sure, Madoff pretended to have a system that delivered much higher returns to his client – all of which was a fraud. He called it his “split strike conversion strategy.” That was one side of the pretense. But what about the other side – the victims? Might they be complicit in this historic fraud?
As more and more is revealed about this case, we see almost all those involved were pretending to understand Madoff’s system, even the regulators who were supposedly the enforcement officers and public’s protectors.
The climate was right given that almost no one fully understood the complex constructs of Wall Street financial engineers. But it didn’t matter as long as greater fools could be found to buy them (see November blog). So the instruments of the trade had gotten so complicated that fewer and fewer people understood how they worked much less what they were worth. So Madoff’s “secret strategy” went unchecked given the market was already so complex and confusing when he started his fraudulent activities in the early 1990s.
Then you have the incredibly rapid pace of computer-generated trading driven by higher and higher demands for fast returns – a very impatient marketplace. With the market being driven into a frenzy by a culture of greed and instruments so complicated few people understood what they were buying, Madoff had a fertile field to harvest with a little flimflam and fast talk. People assumed Madoff was one of the elite few who understood how these things worked and their proof was in the returns he appeared to be delivering.
While no one understood what he was doing, they pretended to know enough to invest with him, most likely feeling very fortunate to be one of the “insiders” who had Madoff as their Wall Street knight in shining armor.
Madoff manipulated one of people’s greatest fears, the fear of looking stupid, and pitched his system so they felt they should understand what he was doing even though they didn’t. Over the years I have seen many examples of people, especially smart people, shy away from asking what they might perceive as “stupid questions.” This conversation with oneself may translate into something like: Well, I’ve had it explained to me and it sounded good, maybe too good. But I should understand given all he told me. My friends like this guy and enthusiastically endorse him and they must understand it. If I ask a question I may look dumb so why not just let it slide and go along with my friends.
If people who invested money they could not afford to lose had been willing to fully comprehend what they were getting into and insisted on this before they turned over any of their fortunes, they might have missed an opportunity to score big in the market, so there might have been some investor greed in play here. .But if everyone had been willing to ask “stupid questions” and risk being judged as dumb, they might have avoided the devastating losses they suffered because they didn’t want to look bad.
Since I am not a banker, I sent an early draft of this article to two friends with investment banking background requesting their frank critique, even if they were to tell me this was ridiculous. A woman with decades of experience in commercial then investment banking responded with a thoughtful email which included the following:
You certainly have hit a very valid point here regarding the human fear of looking dumb. I encountered this when I was in the private bank and the clients began asking to get into derivatives – they had no idea what they are or what to do with them. We were required to tell them how risky these instruments are and that they are not for the average consumer – it seemed like the more you told them, the more they wanted them.
The other person I sent it to had been a principal in an investment firm, not merely an employee. He wrote in part:
Madoff created a notion of scarcity thus increasing the desire of investors to participate. Those who were privileged to be part of this elite “investor class” were special. Sort of like carrying a Gucci bag or wearing an Armani suit. They became members of this special Madoff Club. Then, there were those who learned of the great returns and thought, “If Joe is doing this, it must be ok because Joe is really smart and wouldn’t do this if he weren’t.”
So this concludes my venture into the psyche of the people who allowed this historic calamity to occur. While they may not have done anything criminal they did play a role through silence (as with some of the investors) and incompetence (as with the regulators). It seems to me this has a parallel with the silent legitimacy we continue to give to our political leaders who seem incompetent to deal with crises facing us all while we wishfully think that somehow they will find the will and the competence to come through for us.
* (courtesy of Wikipedia) A Ponzi scheme is a fraudulent investment operation that pays returns to separate investors from their own money or money paid by subsequent investors, rather than from any actual profit earned… The scheme is named after Charles Ponzi, who became notorious for using the technique in early 1920.